Starting a Hedge Fund as an Emerging Manager

December 12, 2013

Share:

Emerging managers face various challenges in their pursuit to start hedge funds. There are a multitude of issues to consider, from planning how to raise capital to choosing service providers to support the business. With a limited history to rely on, managers need to demonstrate an ability to generate returns for potential investors whilst meeting the ever-changing demands of the regulatory environment.

"If you're not somewhat different, you need to be materially better and that can be hard to prove as an emerging manager."

Raising Start-up Capital

Capital raising has drastically changed over the years and is proving to be increasingly challenging for emerging managers. Although attracting investors and raising substantial amounts of capital may seem like an overwhelming process, there are various alternatives that they can explore.

"Emerging fund managers should develop a capital raising strategy based on the stage of the fund's life cycle. A fund that is just starting should focus on friends and family and seed investors while a more established fund will begin to focus on institutional investors."

– Nicholas Tsafos – Partner, EisnerAmper LLP

Raising Start-up Capital

Friends & Family

Seed Investors

Founders' Class Shareholders

Capital Introduction Groups

One of the first places that emerging managers look to raise money from is friends and family.As with any other type of potential investor, managers should be ready to discuss in detail the fund's structure, investment strategy and service providers.

Seed investors (or "seeders") provide emerging managers with early stage capital and in some instances may also provide additional support services, such as marketing, in exchange for an agreed-upon percentage of the fund's revenue (which may include a share of both management fees and incentive fees).In some arrangements the seeder may acquire a portion of the management company and/or general partner entity. This may contain a provision for the fund manager to buy out the seeder's interest in the future.

Funds frequently offer a separate class of shares with preferential terms and reduced fees to their initial investors.Funds typically adopt a '2 and 20' compensation model under which the fund manager charges management fees equal to 2% of the total net asset value, and is allocated incentive fees in the amount of 20% of any profits earned by the fund. Founders' class investors are instead charged reduced management and/or incentive fees.Generally, this share class is closed after a certain period of time has passed or once a certain amount of capital has been raised.

Capital introduction groups help emerging managers market themselves and aid in better aligning the fund to the most suitable investor demographic based on the fund's structure and investment strategy.Prime brokers and third-party marketing services often take the form of an intermediary by linking emerging managers to potential investors.Emerging managers can make use of capital introduction groups to gain access to investors that would otherwise be hard to reach, such as retirement and pension plans, trusts, endowment funds, and other large institutional investors.

"Who your investors are going to be will be a primary driver of your fund's structure."

– Jason Grunfeld – Partner, Kleinberg, Kaplan, Wolff & Cohen, P.C.

Fund Structure

Fund Type

Under the Investment Company Act of 1940, private funds, which are excluded from the standard registration requirements of the SEC, are commonly categorized under two sections of the Act: sections 3(c)(1) and 3(c)(7) ("3C1" and "3C7" funds). Initially, since an emerging manager tends to attract friends and family to their fund, they generally set up a 3C1 onshore fund. As a 3C1 fund grows, the manager can form a 3C7 fund and transfer those partners that qualify to the 3C7 fund so the total number of investors is able to grow. As tax-exempt and offshore investors are attracted to the fund, the manager would then consider opening an offshore fund (either 3C1 or 3C7). U.S. tax-exempt investors typically subscribe to an offshore fund, as the corporate form of the offshore fund enables the blocking of any unrelated business taxable income (UBTI) from flowing through to the tax-exempt investors. A fund manager may then consider opening a master fund and have both the onshore and offshore funds as feeder funds as each begins to mature, which would eliminate the need for two separate investment portfolios.

Management Structure Considerations

The fund manager also has to decide the structure of the general partner (GP) and the management company, which are usually set up as pass-through entities. The structure chosen may have tax implications with regard to self-employment tax and net investment income tax.

Inception may be the best opportunity for estate planning as business valuation is typically at its lowest point.

There might also be tax ramifications if the GP and management company are not set up separately. For example, if the fund operates in New York City, it is important to set up different legal entities for the GP and the management company so the incentive allocation received by the GP (usually 20% of income) is not tainted by the management fee earned by the management company (usually 2% of capital), which is currently subject to a 4% tax in New York City (net of operating expenses).

"While it has become common over the last several years to structure incentive from offshore funds as an allocation, some funds are revisiting an incentive fee approach, due to recent tax legislation, such as Net Investment Income Tax."

– Jeffrey Parker – Partner, EisnerAmper LLP

Fund Strategy

Being able to clearly articulate a well-defined investment strategy is paramount to capital raising, and may also influence the ultimate fund structure and selection of service providers.

Understanding the tax implications to a fund's stated strategy is another significant step when starting out. Whether the fund is classified as a 'trader' or 'investor' can have deep tax ramifications. Different financial products or trading strategies may generate significant book/tax differences. Further, certain types of investments are potentially subject to state and/or local taxes and may have additional tax consequences for foreign investors.

"If you are exploring a strategy that involves a significant amount of borrowing, you may want to set up an offshore fund from inception."

– Michael Laveman – Partner, EisnerAmper LLP

Service Providers

Service providers play important roles in the various life-cycle stages of a fund, as they provide the advice and expertise which shape the fund for its lifetime. Below is a glance at some of the appointments an emerging manager needs to make to help provide for the needs of investors.

"2008 and the rise in regulation have really changed the administrator space."

– Fred Jacobs – Head of Global Business Development, SS&C

"Your prime broker's cap intro team should be willing to consult with you through the process of building your presentation and refining your message."

– James Zurlo – Senior Vice President, Concept Capital

Service Providers

Administrator

An administrator provides several services, including back-office accounting, portfolio reconciliation and valuation, and offers transparency to investors through reporting of the fund's net asset value. When appointing an administrator, the fund manager needs to examine its technological capabilities to see if they are appropriate to provide the fund and its investors with timely data, analysis of their investment and compliance services. Fund managers and investors are requiring real-time access to information through an interface portal. Although a fund may outsource various roles to an external administrator, they should certainly conduct their own internal review of the information.

Prime Broker

Prime brokers provide trading and custodial services to funds. Additionally, the prime broker may assist with capital raising and other financial needs of the fund. Investors prefer a recognized prime broker. Prime brokers, similar to administrators, also need to provide timely information to the fund.

Tax Advisor

A tax advisor is a valuable resource to ensure the needs of different investors are met through the creation of appropriate tax structures. A tax specialist remains a key advisor as both the fund's and investors' needs change over time. They also help fund managers stay in compliance with tax-related issues as they arise, such as the Foreign Account Tax Compliance Act (FATCA).

Auditor

The auditor's work is a critical factor considered by investors as they place reliance on their independent work. The auditor will support the fund's level of transparency and a reputable audit firm with a recognized competency in the hedge fund industry will provide greater comfort to investors. A reputable audit firm can also play a role from a marketing standpoint, especially when dealing with institutional investors.

Attorney

Attorneys assist with the creation of the fund from a legal perspective to help fund managers comply with the increased regulation and legislation both currently in place and proposed for the coming years. In addition, they also provide support in the setup of the management company and general partner entity to enable profit maximization for management.

Operational Due Diligence

Operational due diligence has continued to grow in importance and has become a key element during the decision-making process of investors.

"If there's one thing compliance is supposed to do, it's monitor trading. And if your trader is chief compliance officer, there is effectively no compliance."

– Simon Fludgate – Head of Operational Due Diligence, Aksia

When an investor is considering investing in a fund, they are giving consideration to historical performance, investment strategies, how the manager operates their business, and the organization's ability to provide information. Key areas that an investor will consider while conducting operational due diligence include:

Operational Due Diligence

Fund Terms

Fund and management structure including fee arrangements and liquidity provisions.

Back Office

Investment in people and processes that prove the staff can adequately support the operations with a clear segregation of duties.

Trading Processes

Robust internal systems to handle the daily trading volume and efficiently process all trade functions from the time a trade is generated to execution and reconciliation.

Valuation Policies

Methodologies stated in the offering documents are employed; manager's valuation policy is transparent, clear, reviewed by a third party, and reconciled.

Safeguard of Assets

Clear safeguards in place to monitor and control cash movements.

Service Providers

Independent service providers with significant hedge fund experience will play a signficant role in supporting transparency and building the trust of investors.

Independent Governance

For offshore funds, there is a high demand to appoint at least three directors on the board including two who are independent.

By concentrating on these areas, hedge funds managers are able to demonstrate transparency, reliability and alignment of interests with their investors.

EisnerAmper LLP is recognized internationally as one of the premier firms providing audit, tax, and advisory services to the financial services industry. For more information please visit our Hedge Fund Services Page.

EisnerAmper LLP is among the nation’s largest full-service advisory and accounting firms. We provide audit, accounting, and tax services, as well as a complete suite of professional advisory services to a broad range of clients across many industries. We work with businesses of all sizes, including more than 200 public companies, as well as with high net worth individuals and family offices. We serve thousands of financial entities spanning the hedge, private equity and venture fund space, along with broker dealers and insurance companies. As companies grow we help them reach their goals every step of the way.